For decades, research and development spending was one of the most startup-friendly areas of the U.S. tax code. Young companies could immediately deduct qualifying R&D expenses, reducing taxable income, preserving cash, and extending runway during their most fragile years. That changed materially with the implementation of Section 174 capitalization and amortization rules.
For founders, finance leaders, and investors, understanding how Section 174 R&D amortization works is no longer optional. It directly affects cash flow, tax liabilities, hiring decisions, and long term runway planning. This article explains what Section 174 is, why it changed, and how it reshapes the financial reality for startups.
What Is Section 174?
Section 174 of the Internal Revenue Code governs how businesses treat research and experimental expenditures for tax purposes. Historically, companies could choose to either deduct these costs immediately or amortize them over time.
The original intent of Section 174
Section 174 was designed to encourage innovation by allowing businesses to expense R&D costs in the year they were incurred. Policymakers recognized that research is inherently risky, often produces no immediate revenue, and benefits the broader economy. Immediate deductions helped offset that uncertainty and supported early-stage investment.
What changed under the Tax Cuts and Jobs Act
The Tax Cuts and Jobs Act fundamentally altered this treatment. Beginning with tax years after 2021, all Section 174 R&D expenses must be capitalized and amortized, with no option for immediate expensing.
Under current law:
- U.S. based R&D expenses are amortized over five years
- Foreign based R&D expenses are amortized over fifteen years
- Amortization begins using a mid-year convention
These rules apply regardless of whether a company is profitable.
Why Section 174 Matters So Much to Startups
Startups typically spend heavily on R&D while generating little or no revenue. The shift from immediate deduction to long-term amortization dramatically changes their tax profile.
Accounting losses do not eliminate tax impact
Most early-stage startups operate at accounting losses. However, tax deductions determine net operating losses and future tax attributes. When deductions are delayed, taxable income can increase even when the business is economically unprofitable.
Cash flow is the real constraint
While Section 174 does not change book expenses, it does change taxable income. Higher taxable income can result in:
- Unexpected federal or state tax bills
- Reduced cash reserves
- Shorter operating runway
For companies with limited access to capital, these effects can be severe.
What Qualifies as Section 174 R&D Expenses?
One of the biggest surprises for founders is how broad Section 174 actually is. It extends well beyond what many associate with the R&D tax credit.
Section 174 generally includes costs incurred to develop or improve a product, process, software, technique, formula, or invention.
Common examples include:
- Software development salaries
- Engineering wages and benefits
- Product design and testing costs
- Prototyping expenses
- Certain cloud computing costs directly related to development activities
Software development is the largest driver
For technology startups, software development expenses are often the most significant category affected by Section 174. This includes software developed for internal use as well as software intended for sale or licensing.
Even early-stage coding and experimentation that precede commercialization typically fall within Section 174.
How Capitalization and Amortization Actually Work
The mechanics of Section 174 are straightforward in concept but impactful in practice.
Mandatory capitalization
All qualifying R&D expenses must be capitalized. There is no longer an election to expense them immediately.
Mid-year convention
Amortization begins at the midpoint of the taxable year. As a result:
- Only half a year of amortization is allowed in the first year
- Five-year amortization effectively spans six calendar years
- Only 10 percent of U.S. R&D costs are deductible in year one
The remaining deductions are spread over future years, delaying the tax benefit.
A Simple Example: The Startup Tax Disconnect
Consider a startup with:
- $2 million in R&D expenses
- $500,000 in non R&D operating expenses
- No revenue
Under prior rules
- Total deductions: $2.5 million
- Reported tax loss: $2.5 million
- No current tax liability
- Significant net operating loss carryforward
Under current Section 174 rules
- Only ~$200,000 of R&D is deductible in year one
- Total deductions: ~$700,000
- Taxable income increases by ~$1.8 million
Depending on entity structure, state conformity, and prior-year losses, the company may owe taxes despite having no revenue.
This disconnect between economic reality and taxable income is the core challenge created by Section 174.
Interaction With the R&D Tax Credit
The R&D tax credit remains available and is still valuable, particularly for startups that can apply it against payroll taxes.
However, the timing mismatch matters:
- The credit reduces tax liability
- Amortization delays deductions
In many cases, the credit helps, but it does not fully offset the increased taxable income caused by capitalization. Startups must model deductions and credits together rather than viewing them in isolation.
Implications for Financial Reporting and Investors
Section 174 affects more than tax returns.
Deferred tax assets matter more
Capitalized R&D creates deferred tax assets that reverse over time. These balances are increasingly scrutinized during audits, financings, and acquisitions.
Cash runway calculations change
Higher tax payments reduce available cash, directly impacting:
- Burn rate calculations
- Fundraising timelines
- Valuation discussions
Investors increasingly expect founders to understand and proactively manage these effects.
Operational and Hiring Consequences
Tax policy influences behavior, and Section 174 is no exception.
Engineering compensation represents a large portion of R&D spend, which can pressure startups to reconsider hiring pace or team structure. Additionally, foreign R&D faces a much longer amortization period, making offshore development significantly less tax-efficient than before.
Compliance and Documentation Are No Longer Optional
Section 174 increases the burden on startup finance teams.
Companies must:
- Identify which employees perform R&D
- Allocate wages between R&D and non-R&D activities
- Track qualifying development-related cloud and software costs
Poor documentation increases audit risk and complicates due diligence. Given evolving guidance from the Internal Revenue Service, close coordination with experienced tax advisors is essential.
Legislative Uncertainty Remains
There has been ongoing discussion in Congress about repealing or delaying Section 174 amortization. While bipartisan support exists, there is no guarantee of relief, retroactive or otherwise.
Prudent planning assumes current law remains in effect. Any future changes should be treated as upside, not as a base-case assumption.
How Founders Can Plan Strategically
Section 174 is manageable with preparation and transparency. Key steps include:
- Building tax payments into cash-flow forecasts
- Modeling amortization schedules alongside runway projections
- Maximizing R&D tax credit utilization
- Improving internal cost allocation and documentation
- Communicating impacts clearly to investors and boards
Final Thoughts
Section 174 R&D amortization represents one of the most consequential tax changes for startups in recent years. By converting immediate deductions into long-term amortization, it reshapes cash flow, tax exposure, and strategic decision-making.
For founders and finance leaders, Section 174 is no longer a niche tax issue. It is a core component of startup financial management. Those who understand it early, model it realistically, and communicate it clearly will be far better positioned to navigate this new environment.